JakilaTheHun (99.91)

Spain, the Gold Standard, Eurobearishness, and the Impoverished Dwarf Army

59

For someone who gleefully dove in at the bottom of the bear markets in late ’08 and early ’09, you’d think I might be more optimistic about Europe right now. Unfortunately, I am not convinced. The more the crisis goes on, the greater my level of fear becomes. This is almost a complete reversal from the deep market plunges of late ’08 and early ’09, where I was buying in like a mad man.

Maybe my fears are completely irrational and I should see the “deep value” screaming out at me from back in the “Old World.” Then again, maybe there are all kinds of warning signs that should be flashing to all investors right now.

It’s been a long time since the Great Depression and an even longer time since the major panic events of the Gilded Age / Belle Epoque. Most people don't even have an awareness of the Long Depression any more.

The general public and even major policymakers have seemingly discounted knowledge from previous eras that suggests inflexible monetary policy can create major economic instability. So I want to explore the gold standard and the Eurozone under this prism. Moreover, I want to look at China’s dollar peg and how it affects the American consumer.

The Gold Standard

We’re seeing many people advocate a return to the gold standard. This would be very ill-advised, not to mention highly impractical. It would have a devastating effect on world economies.

The reason the gold standard can be so economically destructive is that it links a nation’s currency to a highly volatile commodity. Money supply then becomes completely dependent on the supply of this precious metal, thereby linking money inextricably to shifts in commodity markets. When a new low-cost gold resource is discovered and mined, this increases money supply, creates implied inflation, and stimulates economic growth (due to a weakening currency).

However, when gold becomes more scarce and the implied prices push upward, this creates extremely strong money, which then functions as an “investment” rather than a medium to exchange goods and services. Once “money” is no longer “money”, investment in the economy suffers dramatically (with the exception of gold mining, which becomes the only profitable enterprise), and the economy contracts dramatically. This situation is exacerbated in a world with rapidly increasing population and a dwindling supply of gold.

Price stability is theoretically one of the major reasons behind the gold standard, but in actuality, the underlying volatility of gold creates price swings that undermine stability, creating periods of both high inflation and severe deflation. This makes banking crises much more likely under a gold standard and might even create higher market interest rates (due to this volatility risk).

No wonder the gold standard was thrown out the window during the Great Depression. Not surprisingly, there was a strong correlation between economic recovery and going off the gold standard.

A return to the gold standard would not only be ill advised, but completely impractical. Moreover, it would be extremely economically inefficient. Think about all the labor, resources, and expenses needed to mine gold. Instead of being used to develop new technologies and create new products to improve people’s lives, we would have to waste billions per year to discover “money.”

I am now officially the least popular person in the entire Land of Foolery, but I am willing to live with this distinction if it brings us any closer to the truth.

The Eurozone

You might wonder what the gold standard has to do with the Eurozone. The answer is that the Eurozone’s structure is not much more flexible than the gold standard. The Eurozone is a bizarre entity, because it deprives every nation within of monetary flexibility. This might not be an issue if the Eurozone were able to enact fiscal policy, but it cannot. So the Euro becomes somewhat similar to the gold peg. The two situations are far from 100% analogous, but they still have a lot in common.

From this perspective, the Eurozone crisis is not a fiscal crisis; so much as it is a monetary crisis. This is why austerity will likely not work; at least not on a grand scale. Yet, austerity has been the solution of Germany and France (i.e. the major powers behind the Eurozone).

This is not to suggest I am advocating reckless deficit spending. Rather, I’m suggesting that the Eurozone nations are caught in a Catch-22 right now. If they cut their budgets, they exacerbate their economic contraction, which lowers GDP, and increases their budget deficits, rather than eliminating them. On the other hand, if they continue to spend, their debt load continues to move upwards and their GDP might stay level or grow by a small amount.

Spain

In a way, the Greek crisis was not that big of a deal. Greece accounts for only a small percentage of world production, but the scary thing about the crisis is that it has showcased the Eurozone’s flawed design in dramatic fashion. Greece does not scare me; it’s Spain that scares me.

While many might point to Spain’s public debt, I’d be even more concerned about the level of private debt. It’s not that the Spanish government has been “fiscally irresponsible” as many assert. Rather, it’s that the private sector debt, coupled with inflexibility in monetary policy, has created a bad situation in Spain. As real estate prices continue to fall and Spanish consumers continue to de-leverage, deflationary pressures will continue to undermine the Spanish economy. These deflationary pressures reduce GDP, which then drive up the public debt, and create a greater likelihood of default.

I wouldn’t sleep on the situation either. There are too many skeletons in the closet in Spain right now. Over the weekend, the Bank of Spain has to bail out regional savings bank, Cajasur. Spanish banks could be sitting on more hidden losses, as well.

In essence, Spain may very well find itself in a deflationary spiral. It can’t escape its public debt without either increasing governmental revenues or decreasing governmental expenses. It can’t increase revenues without either spending more or lowering taxes in order to raise GDP. It can’t decrease expenses without lowering GDP, which then creates larger deficits.

Of course, it’s difficult to say how precisely this situation would play out in real-time. What does the ECB do? Are Germany and France forced to jump in again? I honestly don’t know the answer, and I’m not sure that many people do.

The Greece situation suggests, however, that the Eurozone needs dramatic reforms to remain viable in the long-term. Otherwise, it could fall victim to a deflationary trap that forces the break-up of the Eurozone. If several Eurozone nations are in default, there really seems to be no other option.

So, you might say I’m just a tad bit bearish on the Eurozone in spite of the declines of the past month. I am not convinced it is a viable entity at all and I am not convinced that Eurozone politicians completely understand the problem. Due to this, it’s completely unpredictable what will happen. Severe deflation? Hyperinflation? Both are possible. The former makes the latter more likely. Who wants to invest in that environment?

China

For those who follow me, you know that I’ve been bearish on China since the beginning of this year. I have never fully bought into the China growth story. When I heard about Jim Chanos’ major thesis on China contraction, I was even more convinced.

The other day, I came across Hugh Hendry’s analysis of China and it’s extremely thought provoking. Check out this article for more. I recommend Hendry’s newsletter, which you can download via a link in that article (I can’t link directly to the newsletter).

In Hendry’s analysis, he makes a few excellent arguments. First off, he acknowledges that China creates its Dollar peg in order to stimulate exports. The belief is that this will bring greater prosperity to China. However, Hendry disagrees with this and says it’s the exact opposite. By constantly weakening its currency, China is basically taking from its citizens in order to redistribute to its industries. The end result is not a wealthier China, but a poorer Chinese consumer.

Many people cite China’s extremely low consumer spending as evidence that Chinese culture promotes saving, but this simply isn’t true in any real sense. Rather, China’s Dollar peg simply takes away all power from Chinese consumers. Instead, Americans get lower cost goods, but it comes at a cost here, as well (America’s manufacturing).

Hendry is very bearish on China just like Chanos and I’m still in that same camp. This is not to say that one will not do well if they can find quality companies on the cheap right now --- but in general, I believe that China’s going to go through some extreme pain in the next few years.

Money supply growth is now starting to plummet (after skyrocketing upwards rapidly from 2008 – 2010) and there are signs of huge credit contraction. This will lead to recession. It’s unclear how China’s government will respond, but one way or another, they are being forced to choose between hyperinflation and economic contraction. Neither is appealing.

One has to wonder if Chinese policymakers will finally see the wisdom of letting their currency float, however, rather than try to play mercantalistic games.

That said, there are very attractive buys in China right now if you know where to look. I make no claim of "knowing where to look" in this case.

The Scariest Thing in the World

With all I’ve written about China and the Eurozone, it’s difficult to think that there’s something even more frightening out there, but there is. And maybe most of you know what I’m talking about.

It’s North Korea.

North Korea is a nation of impoverished dwarves. That’s not a joke. The average North Korean is almost half a foot smaller than his/her South Korean counterpart. This isn’t genetics, so much as it is diet. The poverty of North Korea strikes a dramatic contrast with the wealth of South Korea; one of Asia’s most successful economies. The Communist government in North functions more like Pharaohnic Egypt than a modern nation. Kim Jung-Il is hailed as a “God” and the masses starve.

In short, North Korea is a disaster in every way. And the regime is well-armed, insane, and becoming increasingly desperate.

I am very afraid that conflict between North and South Korea will occur within the next few years. It almost has to happen at some point. North Korea can not survive. I’d rather see it go out with a whimper and a peaceful re-unification into the South Korea state. But the powers inside North Korea aren’t willing to go down without taking down a lot of people. Or so it seems.

China will soon experience a recession. The Eurozone has major issues. But the situation in Korea is just outright scary. Let’s hope for the best, but I would definitely prepare for the worst.

Buy U.S.

Given the Eurozone situation, coupled with my own bearish outlook on China, I would say that the U.S. might be the best place to invest right now. I will surely attract the ire of gloom-and-doomers and those with a political ax to grind.

Things aren’t perfect here, but the U.S. handled the credit crisis relatively well. Certainly some mistakes were made, but nothing major. The biggest error in my view was the nature of the stimulus (should have been more infrastructure-focused *or* should have entirely been made up of one-time tax cuts). TARP could’ve been designed better, but it wasn’t the disaster that many were predicting it to be. The Federal Reserve made a lot of missteps leading up to the crisis, but has mostly made reasonable decisions since late ’08.

Given this, the U.S. could see its economy grow over the next few years. Moreover, the China crash might actually help the U.S., by lowering prices for oil and commodities. That said, it’s also possible that the Eurozone situation adversely affects America. We’ll have to wait and see.

I’d keep an eye on both Europe and China, but for the moment, I’d content with U.S. investing.

The scariest thing to me about the US fiscal burden isn’t so much the burden itself, so much as it is the political establishment’s indifference to it. When they do address it, it’s normally in an unhealthy way, or a misleading way (to paint themselves as a “deficit hawk” when in actuality, they are just as bad as everyone else --- see John McCain).

In actuality, however, we could get our deficit under control fairly easily if there were simply political will to accomplish it. Here are the steps I would take to improve the US’s fiscal situation:

(1) Cut military spending 5% for the next 5 years. We spend way too much on the military and American Presidents simply abuse its power.

(2) Phase out Social Security. It’s the most economically inefficient program devised by Washington. The private sector can handle it much more efficiently. Moreover, social security taxes are a huge drag on our economy. Of course, income taxes would probably have to be raised in the short-term to phase out social security, but it would be well worth it in the long-run and any tax increases could be made to sunset at some later date.

(3) End the Drug War, de-criminalize, tax, and regulate marijuana. From the statistics I’ve seen, we actually spend enough money on the Drug War so that eliminating it would probably cut a huge chunk of the budget deficit. Moreover, it would create a new revenue source, and increase GDP.

(4) Simplify the Tax Code. We waste billions per year in American wealth trying to comply with this nightmare of a system. Eliminate all deductions and just create flat rates. It’s fairer and simpler. Why should people who decide to have 8 children get tax advantages over people who have 2 children or chose to have no children anyway? Lower tax compliance costs mean greater GDP and more wealth can be pushed into innovative pursuits.

(5) Repeal Section 404 of Sarbanes-Oxley. This is another drag on our economy. Section 404 requires public companies to hire an external auditor to examine internal controls. It’s not that this information isn’t useful to investors; it’s that the costs of providing this information are overwhelming to small companies. One of the rules of auditing is that it should provide information only if it’s cost-effective and Section 404 is not. By eliminating it, smaller companies would have greater access to capital, which would allow them to grow and innovate. This increases American GDP in the long-run.

(6) Lower Taxes. This would be higher on my list, except we have too huge deficits right now for it to be practical. But if we were able to get the deficit under control, I would lower taxes. Lower taxes will help increase GDP. Higher GDP means higher governmental revenues. Moreover, our debt-to-GDP ratio falls.

No one in Washington is listening to me, but I do believe that with these six steps, our fiscal condition could be improved. As I’ve said, the problem isn’t that it wouldn’t work – it’s that there’s a lack of political will.

Actually, I'm good with all of it. That said, I don't think we need to get rid of Social Security however, all the political manipulation since it's inception should be overturned and then reevaluate the core program. Remember, this has been a petty cash system for government for a long time. Perhaps it's time the government paid it's tab.

Sarbanes-Oxley has not been effective because it has not been enforced. If the SEC caused some perp walks for financial CEOs and CFOs, it would be having the intended effect. Otherwise, it has been just a big waste of money. Where is the SEC?

People want gold standard because they think gold will protect them from irresponsible governments printing money to cover their debt. They think gold standard will force their government to be more prudent because it will take the control of the monetary policy out of the hands of governments and give it to the free market.

However, consider Euro. Euro is a sort of half-way between 100% fiat currency and gold. The individuals countries have no control over euro so it is not very simple for them to print their way out of debts. Euro monetary policy is agreed by the gorup of contries, germany being the major influence and therefore it is very conservative and prudent.

Yet, for all its prudent policies euro right now is in the middle of the huge crisis whereas USD is a "safe heaven". It is really a travesty. But it shows exactly why the gold standard won't work.

Monetary policy needs to be flexible. Yet it shouldn't be at the whim of politicians or special interests (read banks and the FED) because it allows them to steal the wealth of the population via inflation. The population should haver a say when parting their wealth in order to support inbalance in the economy.

Logically, the fiat currency and the monetary policy should be regulated by the free market forces of supply/ demand. But how to achieve that? I am not sure. But I am sure that gold is not the answer.

The one argument I have is with repealing Social Security. I have come to the conclusion that most people are too stupid to be allowed to not save for retirement. While the SSA is amazingly bad, we need some sort of enforced savings vehicle. It might better be administered by private industry, but contributions should not be voluntary.

Logically, the fiat currency and the monetary policy should be regulated by the free market forces of supply/ demand. But how to achieve that? I am not sure. But I am sure that gold is not the answer.

I agree. I'd go a step further and suggest that there is no way to create "free market" currency. Currency, by its nature, must be created by fiat.

I'd advocate stricter monetary policy than the Fed has become known for, but I don't believe gold is the answer. If there is a nation that has come close to achieving what I advocate, it would be South Korea.

Most people here do not like their policies because they keep higher inflation targets (3% - 5%) than the US (0% - 2%), as an example. However, I'd argue that this is the ideal rate. It's high enough to deter speculative bubbles, but low enough to create price stability.

There will always be inflation so long as there is population growth, so I think people who want to eliminate inflation are being unrealistic. Price stability should be the goal. Inflation from 0% - 5% on an annual basis is reasonable. I think 2% - 5% is the ideal range for stability.

People want gold standard because they think gold will protect them from irresponsible governments printing money to cover their debt. They think gold standard will force their government to be more prudent because it will take the control of the monetary policy out of the hands of governments and give it to the free market.

I agree --- gold won't protect from irresponsible governments. There have been no shortages of reckless policymakers under gold-standard regimes.

The gold standard merely creates arbitrary monetary policy and once that creates depressionary conditions, the government will merely revalue the gold peg to its suiting. I'd rather have predictable inflationary policy than arbitrary one-time revaluations.

Uhh.....did I miss the section advocating a reduction in spending on "social programs"? By tightening eligibility requirements, eliminating the system of increasing benefits based on increasing dependents (more $ for having more kids you can't afford), and limiting the benefits to LEGAL RESIDENTS AND CITIZENS ONLY, the expense of such programs as welfare, food stamps, section 8 subsidized housing, etc, etc, ad nauseum could be reduced to a truly manageable level.

No meaningfull reduction of the deficit (much less the total National Debt) can be accomplished until these out-sized programs are reigned in.

If we keep giving away the farm, we shouldn't be surprised if we continue to find the cupboard bare.

"I am now officially the least popular person in the entire Land of Foolery"

I think LordZ still holds that distinction. He got switched with the banstick if I recall.

"It’s unclear how China’s government will respond, but one way or another,"

My guess is they will try to choose more door number 3. I.e. fraud and phoney production like the City of Ordos. Try to keep the illusion going as long as possible.

" I would say that the U.S. might be the best place to invest right now."

Better than brazil or India or Canada? I do think Brazil is pretty heavily interlinked tradewise to China though...

"In short, North Korea is a disaster in every way"

I'm with ya

I've often said that I'd rather we'd invaded North korea tha Iraq. I'd rather not invade anybody. But if we were going to do a pre-emptie strisk on one of the so " Axis of Evil " President Bush named, North korea was the only one that actually worried me.

on sugestions 1-6

I largely agree with 1-4

although I'm not sure Social Security is as problematic as medicare/medicaid. And I'd be hesitant to see what Wall Street would do to it if they got their hands on its' replacement somehow.

5 I have to study. But in general I think SOX is written in an ineffective manner. Actually I think SOX is likley not only hurting smaller companies but actually hurting transparency as it's incentivized companies to public through Reverse mergers and SPACs. There has been a huge spike in reverse mergers since 2004. Coincidence? I don't think so.

6 is something I'm sure everyone would like of any political persuasion, but it seems pointless without far greater fiscal restraint than either party has shown themselves to be capable of. Actually suggestion 4 might be more beneficial than 6. The sheer amount of time saved would probably be immense.

TOT is very cheap. Their product isn't completely dependent on Europe, either.

If Europe can straighten out its messes, there are a lot of stocks that will be cheap (in hindsight). But I'm relunctant to green thumb a lot of them because I'm not overly impressed with the responses thus far.

Companies like TOT, VE, and ABB, that have operations worldwide are probably in relatively good shape regardless. Even European telecoms might be great investments. I'll admit to being long OTE and FTE, but I'm not jumping on much more than that for now.

But if we were going to do a pre-emptie strisk on one of the so " Axis of Evil " President Bush named, North korea was the only one that actually worried me.

I agree completely. Iran and Iraq (under Saddam) were never threats to American security. Saddam was desperate to hold onto power and would not do anything to jeopardize that. The powers-that-be in Iran are also unwilling to jeopardize their own security.

Kim Jong-Il is an entirely different creature. He's insane. He's set himself up as a God and has lost touch with reality. Or alternatively, he knows the US and South Korea will typically backdown from confrontation and he exploits this to his advantage heavily.

Of course, this is actually why North Korea was the only one of the "Axis of Evil" nation Bush did not confront. My theory on why Bush started the Iraq War is that he wanted a war that could be "won." He knew that historically, Presidents that won wars were extremely popular. It didn't even matter if the war was based on phony premises.

The thing that has actually convinced me of this is Obama's adventure in Afghanistan. It's becoming clear that it's not easy to "win" Afghanistan, whereas taking out (very weakened) Saddam was always going to be a breeze. Instead of facing the *real* conflict, Bush decided to create a phony one.

He underestimated the intelligence of modern Americans, however. In an age of rapid transfer of information, people were well aware from the get-go that the war that a lot of the propaganda he was spewing out sounded misleading. Moreover, in spite of the fact that we've been very successful in Iraq, most people regard it as a "failure." Which is how it should be regarded, given the debt we acquired to achieve our objectives there.

The reason the gold standard can be so economically destructive is that it links a nation’s currency to a highly volatile commodity.

If I wasn't on vacation I would happily take you to task on this. Was the gold supply volatile, or does gold look volatile today because in relation to paper currencies it fluctuates? (Which simply means that paper is volatile.)

However, your solutions 1-6 are all excellent and they roll back the State, which is very good. I think you could cut military spending by 100%, but hey I'll take 5 if that's all we are offering today :)

Btw, the Fed makes all of it possible, the Drug War, the miliary spending, the ridiculous SocSec scam. Without the Fed, you'd be taxed at 100% and you would have put a halt to all of it by now. Just sayin....

Fantastic blog Jakila. Your comments on the gold standard are in line with my views, but I lack your eloquence of expression. Although I think you are correct to be bearish on China for the time being, I think that Chinese equities are extremely attractive for the long term. When the current dive turns around I am going to make a huge investment in China because: (1) the long term prospects are still excellent and (2) the currency is a one way bet. After Japan floated its currency (in the eighties), the currency TRIPLED in value. Purchasing power parity and current levels of currency manipulation by the Chinese government suggest that the same would is likely to occur when China floats its currency. It may be more than a little bit coincidental that period of worldwide prosperity followed after Japan floated its currency - thereby restoring balance to a world that seemed quite unbalanced in the seventies. I am going to do more research to confirm/refute my theory that Japanese equities initially thrived after devaluation - only to stagnate later. Would expect similar path for China.

When the current dive turns around I am going to make a huge investment in China because: (1) the long term prospects are still excellent and (2) the currency is a one way bet. After Japan floated its currency (in the eighties), the currency TRIPLED in value. Purchasing power parity and current levels of currency manipulation by the Chinese government suggest that the same would is likely to occur when China floats its currency. It may be more than a little bit coincidental that period of worldwide prosperity followed after Japan floated its currency - thereby restoring balance to a world that seemed quite unbalanced in the seventies.

Very interesting observation. I had never thought about the time period of the Japanese Dollar peg strangely coinciding with the major economic stability in the world from the early '70s to mid '80s.

If I'm not mistaken, they eliminated the peg in 1985 and then their property bubble burst in 1990, right?

I actually think there are some great bargains in China right now --- I'm just finding it difficult to separate the gems from the frauds right now. I've found a few companies I like in China, but not much more.

If I'm not mistaken, they eliminated the peg in 1985 and then their property bubble burst in 1990, right?

You are correct in substance. The political details turn out to be a bit more interesting. The peg was officially eliminated in 1973 when the exchange rate was 300 Yen to the dollar, but the Japanese government continued to intervene intensely. The historical yen/dollar exchange data in Wikipedia shows that the Japanese govenment succeeded in keeping the exchange rate at approximately 250 Yen to the dollar until 1985. In 1985, France, Germany, the United Kingdom and the United States pressured Japan into signing something called the Plaza Accord. This accord stated that the Yen was undervalued in relation to the US dollar and the various parties agreed to intervene to increase the value of the Yen in order to promote worldwide economic stability. By the end of 1985, the exchange rate declined to 200 Yen to the dollar. The Japanese stock bubble burst in 1990 as you stated above. The all time peak of the Nikkei was 38957 on 12/29/89, which compares favorably to its value today (i.e. 9460). I am not sure what to make of all this, but I believe it is a relevent example when analyzing the economic impacts of China/US exchange rates and trade imbalances.

When the Plaza accord was signed on 09/22/85, the Nikkei was at 12667. Thus, a US investor in Japanese securities would have tripled his money from 09/22/85 to 12/29/85, excluding dividends. This works out to 30% per annum plus dividends. Not bad for buying and holding an index. Some, but not all of this gain was fueled by the fact that the Yen/dollar exchange rate decreased from 200 to 143 over the same time period.